Homebuilders Deserve a Second Look

Homebuilders are the worst-performing industry in the Standard & Poor's 500 Index for the past month, down 10% while the index was up 5%. I believe this may give investors a second chance to get onboard a group that I expect to do well the next two to three years.

The shares have been weak because investors see interest rates starting to move up, which could make it harder for people to afford new homes. But I believe traders and investors are missing an important point.

Many people will pull the trigger on buying a new home when they say to themselves, "Better do it now, before mortgages get too expensive." That phenomenon is likely to continue throughout 2013 and 2014, as rates continue to inch up sporadically.

The situation is analogous to the firearms industry. The possibility of stricter gun control is seen as a threat to the industry. Yet sales for Sturm Ruger (RGR) and Smith & Wesson Holding (SWHC) have been extraordinarily strong, as people who might want a rifle or handgun buy before it becomes more difficult.

There is no question that the homebuilding stocks have been laggards this year. They are down 9% for the year through July 26, while the S&P 500 was up 20%. That swoon followed a superb 2012. Homebuilding shares doubled last year, off a very depressed base.

I believe that with affordability now at good levels, with home prices rising and with mortgages still at attractive rates, demand will be strong both for existing houses and new homes. Home prices fell about 30% from the July 2006 peak to the May 2009 trough, and have been rising slowly and erratically since then.

The homebuilder I own for clients is NVR Inc. (NVR), based in Reston, Va. I picked it about nine months ago because its balance sheet was stronger than that of most other homebuilders. The stock doesn't look cheap on current earnings, selling for about 23x the past four quarters' profits.

It looks better on a measure I call the "malt shop P/E." That is the stock price divided by the third-best earnings figure of the past 10 years. It is a quick way to figure a price-to-earnings ratio based on normalized earnings. For NVR, the third best earnings total was $66.42 in 2004. So with the stock at about $900, the malt shop P/E is 13.6.

Here is where that measure stands for a few other home builders right now. D.R. Horton (DHI) is at 7x "malt shop" earnings, Lennar (LEN) at 9x, PulteGroup (PHM) at 9 x, and KB Home (KBH) at 3x.

Some of these companies have debt-to-equity ratios with which I'm just not comfortable. KB Home, for example, has debt of more than four times equity. But I believe it's a good time for investors to poke around and investigate these stocks. I believe the group will climb substantially in the next two years.